Is the MEV Monster Under the Bitcoin Bed?

What is MEV?

For starters, Maximum Extractable Value (MEV) encompasses a variety of techniques used by market actors to capture additional value by exploiting the pricing inefficiencies of blockchain transactions.

One of the more innocent forms of MEV is called “transaction sniping.”

Most recently, this phenomenon started appearing in local Bitcoin meme pools due to ordinal transactions. Without going into too much detail, the way on-chain transactions currently work is through the use of Pre-Signed Bitcoin Transactions (PSBT).

The concept is simple. Some users list their photos on the marketplace by creating a deal with the details and price they want to sell the photo for. As a cat lover, you can purchase this cat holy grail by completing the transaction and adding your address, transaction fee, and signature. The transaction is then broadcast and eventually settled on the Bitcoin network.

Isn’t it easy?

not really.

It turns out that cats are a hot commodity these days and other fellow cat lovers are taking notice of your product. Due to the openness of offers, any offer may deter you from purchasing. This is because PSBT listings are auctions, not individual sales. All transactions on Mempool involving cats are subject to bidding. Bitcoin’s 10-minute block interval opens up the opportunity for opportunists to “sniper” each other’s transactions for the most valuable pieces. Nothing is settled until a transaction is made into a block.

We learned from this that on-chain auctions are vulnerable to settlement times on established blockchains. This poses a particularly tricky problem for anyone with a little more ambition than trading cat photos.

What causes MEV?

Now what is the biggest problem with MEV? Surely not everyone is up in arms about a few degens outdoing each other for cat pictures?

Answering this question opens a whole new can of worms. This will be a bit of a trip into shitcoin land, but bear with me. I promise it’s worth it.

As you can see, MEV is a large company. To give you a rough idea, MEV-Boost, the software that orchestrates MEV extraction on Ethereum, has distributed nearly 500,000 ETH in rewards in less than two years. That’s almost $2 billion!

What drives this entire market is, of course, trading. (Read: Degens)

On-chain Automated Market Makers (AMMs) use the popular concept of liquidity pools to allow users to trade assets without relying on centralized order books. Pools typically consist of asset pairs such as Ethereum and USDC.

When users want to exchange one asset for another, they interact with these liquidity pools. Each transaction adjusts the ratio of the two assets in the pool, affecting their relative prices. By eliminating centralized order books that must connect buyers and sellers for each transaction, AMMs can be deployed as decentralized on-chain contracts.

Once a trading pair is created, any user can trade against the pool or contribute liquidity. Liquidity contribution involves contributing one or two assets to the pool to maintain appropriate ratios. Imbalances create opportunities for market makers to engage in arbitrage by purchasing cheaper assets from a pool and selling them at a higher price in another venue, such as a centralized exchange. This activity, coupled with the fees that liquidity providers (LPs) incur from trading activity, incentivizes people to keep these markets liquid.

If you’ve heard of DeFi or Uniswap but have never looked into it, this is the secret. Liquidity pools can be deployed to trade any asset and have become very popular due to their permissionless nature. If you look closely, you will see that these transactions are not fundamentally different from the cat markets discussed earlier. This is just an on-chain auction.

As you can imagine, Ethereum’s architecture and additional programmability create a particularly fertile environment for these auctions to be abused and manipulated.

Perhaps the most popular and intuitive method is front running. Remember that AMM transactions are not settled immediately. Just as cat snipers can monitor Bitcoin mempools for interesting transactions, Ethereum also has an army of financial mercenaries diligently watching for every trading opportunity.

Except the ETH boys don’t play with these things. That’s not Private Ryan, that’s SEAL Team Six. They use some sophisticated techniques to take advantage of the time difference between when a transaction is broadcast and when it is confirmed on the blockchain. As a result, the frontrunner can place his trade ahead of the original trade, profiting from the price change resulting from his actions. This results in regular users receiving lower prices than expected. One of the worst signs of this is the practice of users sandwiching a buy order right before a user’s trade and a sell order right after, capturing the price difference at the expense of the original trader.

These dynamics are controversial because of their impact on user experience, but they are only part of the MEV economy. The largest source of MEV, by a fairly large margin, comes from what is commonly known as “loss vs. rebalancing.” Simply put, this is a disadvantageous form of pool arbitrage described above that affects liquidity providers.

If the price of an asset in a liquidity pool is different from the price at which it was originally deposited, arbitrage traders step in to rebalance the pool to reflect global market prices. This rebalancing process leaves liquidity providers vulnerable as they cannot adapt to inter-block market volatility. Their exposure to outdated prices makes them easy targets for traders with access to centralized order books. These traders take advantage of price discrepancies, often resulting in a less favorable asset mix for liquidity providers and a reduction in overall value.

The situation is so dire that a recent research paper on the matter concluded:

Our main result is that for most of the largest Uniswap pools, which currently hold hundreds of millions of dollars, fee revenues are smaller than losses to arbitrageurs. This result raises the question of why LPs contribute capital to these pools.

Other factors, such as hedging, and large-scale operations have helped alleviate these problems, but the extreme conditions described are likely to have resulted in liquidity provision being consolidated into a smaller number of actors.

Why do we care about Ethereum?

Good question, Anon! The reason I mention this is because a lot of the recent conversation about Bitcoin’s MEV completely misses the fact that the system does not exist in a technological vacuum. I understand that new and unknown concepts may invite skepticism, but many of the dynamics involved are now well understood. From a strictly technical standpoint, this is a disservice to all of us.

We understand that there are various new proposals floating around to improve Bitcoin’s scripting capabilities, which could introduce more expressiveness to the protocol. With this combination of features, it is not impossible that someone could build the equivalent of AMM on-chain. It is clear that something on the scale of Ethereum will have a negative impact on Bitcoin’s decentralization. We know that MEV tends to encourage a high level of specialization at the mining level. If you want to better understand the risks at hand, Spiral developer Matt Corallo has written a decent primer on the topic.

Unfortunately, the most important aspect of this topic was almost completely ignored by everyone at the table. MEV and all related systems are driven by economic incentives. Various parameters can have a significant impact on the feasibility of this activity.

Our story about cats shows how the spacing between blocks plays an important role in the game theory of on-chain auctions. This theory is now supported by documented evidence. Researchers generally agree that MEV-related problems get worse as block times increase. This poses a significant challenge to anyone considering building an AMM system on the Bitcoin blockchain.

Is Bitcoin in danger?

Comparing Bitcoin’s 10-minute block interval to Ethereum’s 12 seconds makes one wonder whether the settlement times required for proof-of-work security are compatible across all large-scale on-chain auctions.

Longer intervals between Bitcoin blocks mean that liquidity providers (LPs) are exposed to stagnant prices for long periods of time, making it impractical, if not irresponsible, to invest significant capital. This latency increases the risk of preemption and other forms of MEV exploits. It’s an arbitrage dream!

These observations suggest that on-chain transactions in Bitcoin may not be feasible, even if technically possible. Applications targeting this use case are increasingly optimized for speed and efficiency, leaving little room for Bitcoin to be a competitive option. Capital allocators are likely to be risk averse with this architecture, and users will likely prefer a platform that better suits their interests.

This highlights the importance of economic considerations when assessing the risks and rewards of technological changes to the Bitcoin protocol. Don’t misunderstand. The noise surrounding this conversation is driven by economic interests seeking to replicate MEV’s financial flywheel on top of Bitcoin. Now that attitudes toward protocol-level innovation have changed, they see this situation as a multibillion-dollar opportunity to recycle proven business models.

Many people don’t realize that Bitcoin’s slow but steady payment process acts as a natural deterrent to predatory MEV activity. This is not a comprehensive study and further evaluation is needed to assess MEV risk in layers built on top of the protocol. On the other hand, there are pretty compelling reasons to believe that fears of Bitcoin’s MEV monster may be grossly overrated. The delay inherent in Bitcoin’s transaction finality provides a unique form of protection, making MEV less vulnerable to the same level of abuse seen on faster chains such as Ethereum.